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How to Enter an Iron Condor Spread Trade

By Edited Mar 10, 2014 0 0

It's possible for option traders to make money by taking a neutral stance. How so? One was traders can generate and keep the cash reaped by trading options spreads is writing a bullish credit spread while simultaneously writing a bearish credit spread. The position is called an iron condor. The two spread trades only need to 'frame' the expected target zone, and the underlying stock or index only needs to remain in that zone up until the options expire, to be profitable. Here's how to do it, with an example.

Things You Will Need

A brokerage account with advanced options trading approval

A basic understanding of options trading

An options calculator

Access to option premiums/prices

Step 1

Choose an optionable index or stock that is apt to remain at or near a certain level for the duration of the trade (until expiry). For instance, let's assume IBM shares are currently trading at $85 per share, and are expected to remain between $82 and $88 through the next two months. Let's also assume it's February, meaning the trade would effectively end on expiration day April.

Step 2

Enter the equivalent to a 'bear call' credit spread, ideally one to two strikes above where the underlying stock or index is currently priced. In the case of IBM, that strike price would be $90. So, to enter this side of the iron condor spread trade by selling (shorting) April 90 calls at a price of $275 per contract, and buying April 95 calls at a price of $150 per contract (those are approximations only). The trader collects the net difference of $125 as cash.

The risk to the trader, however, is that IBM will move above $90 before the options expire. With IBM shares priced above $90, the risk that the April 90 calls will be exercised against the iron condor's owner is high.

Step 3

Now enter the equivalent to a 'bull put' credit spread. This is ideally done one to two strikes below the current price of the underlying stock or index. When IBM is trading at $85 per share, this means the credit spread should be written at $80. To enter this trade, April 80 puts should be sold/shorted at $250 per contract, and April 75 puts should be bought at $110 per contract. The trader would collect the net difference of $140 per contract as cash.

With this leg of the iron condor, the risk is that IBM will fall under $80 before the options expire. If they do, the trader's short April 80 puts may be exercised against him/her.

Step 4

The next step is… do nothing until forced to. Between the two sides of the IBM iron condor, this trader has pocketed a total of $235 ($110 + $125) as cash. He or she will get to keep all of it as long as IBM shares don't move above $90 or under $80 before April's expiration day.

Step 5

If the trade's 'safety zone – which is between $80 and $90 in the case of IBM's iron condor - are likely to be reached and/or surpassed though, traders are better-served by defensively closing out the one side of the iron condor trade that's in jeopardy. To wait until the stock exceeds the prices of the long call or the long put (for IBM, the April 95 calls or the April 75 puts) is pointless, as by that time, the maximum loss has likely already been incurred. By closing out one side of the trade even for a small loss as soon as it's clear it could be at risk, at least some net profit on the whole trade could still be preserved. Don't let the length of the explanation fool you - iron condors aren't that complicated. And, by taking on positions on both sides of the underlying stock or index, the potential income is doubled.

Tips & Warnings

* Though not complicated for traders who have placed credit spread option trades before, the addition of another position may prove to complicate matters more than it's worth.... even though income potential is doubled.

* Traders are encouraged to 'paper trade' a few iron condors before committing real capital to such a position. Doing so will increase confidence and experience in handling the unexpected but inevitable curve balls.

* Though iron condors are complex and offer multiple ways to win, traders should not forget that - above all else - picking the right underlying stock or index is the key.

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